David Einhorn is Warning Investors Off Netflix, Inc. (NASDAQ:NFLX)

By Gaurav S. Iyer, IFC Published : September 11, 2015

Shareholders of Netflix, Inc. (NASDAQ:NFLX) have enjoyed enormous success over the last few years. But billionaire investors like David Einhorn warned that the good times wouldn’t last. Back in July, Einhorn hammered Netflix over its cash flow management, seemingly oblivious to how well NFLX stock was performing. (Source: Forbes, July 13, 2015.)

At the time, it was easy to dismiss Einhorn’s analysis as the whining prognostications of a guy whose hedge fund was underperforming. But there’s a reason this guy is an investing legend. When he yells “FIRE,” perhaps you should look around and check if your house is burning.

Einhorn Called a NFLX Decline, Not a Netflix Decline

Netflix stock has shed nearly 19% of its value in the past month, a situation that few would have expected earlier in the year. Obviously, Einhorn is the exception.

But what’s causing the decline? Are Netflix shares going through a simple but harsh correction, or is there a bigger sell-off to come?

Although he’s unimpressed by Netflix’s House of Cards, Einhorn isn’t arguing that Netflix is a terrible business. People tend to hear it that way because conflict is enthralling and exciting, but his main point is actually quite bigger than that.

Successful companies aren’t always profitable investments. Business can be booming, but unless that company’s prospects are underappreciated by the broader market, investors will not find an extraordinary return there.

That’s what Einhorn is talking about. After doing a fundamental analysis of the business, investors should ask themselves whether or not the stock is fairly priced. If it’s undervalued, then buy like there’s no tomorrow.

Economists tell us that when information is open and free, markets will match the right price to the right stock. But the problem is figuring out which pieces of information, when sown together, present the truest version of the future.

That’s why legendary investors like David Einhorn are so wealthy. By stepping back from the sea of randomness, they see the bigger picture and can invest accordingly.

Revenues jumped 22.7% year-over-year in the second quarter, but net income fell more than 63%. Part of the reason is that Netflix is expanding overseas and adding to its list of original content. Hard as it may seem, these are necessary investments. (Source: Netflix 10-Q Filing, July 17, 2015.)

There’s a tectonic shift underlying Netflix’s earnings decline, and it will play out in the next two to three years. The company licenses its content from a range of Hollywood studios and was the market leader in online streaming.

However, Netflix’s monopoly is threatened by competitors like Hulu, Amazon Prime Video, and possibly Apple. New entrants have undermined Netflix’s negotiating power with studios, forcing them to pay higher licensing fees or simply lose access to some content.

For instance, the company just ended a deal with Epix, a cable network partially owned by Viacom, Inc. (NASDAQ:VIA). The contract was picked up by Hulu, giving them the rights to megahits like The Hunger Games, Wolf of Wall Street, and Star Trek: Into Darkness. (Source: Vox, September 1, 2015.)

Streaming used to be a backwater distribution channel where movies were sent to die. However, Netflix has transformed the industry. Digital and streaming revenues are widely acknowledged as the future of television and film. But it means a tougher environment than Netflix has faced thus far.

In order to distinguish themselves from competitors, the company needs original programming that will tie viewers to their service. However, the decline in NFLX shares is also logical. The company trades at a multiple of 222.8 compared to an industry average of 40.2.

Here’s the Bottom Line

It’s obvious that investors were bullish on Netflix’s future, but they may have discounted how much the company has to spend in order to defend its market share. David Einhorn certainly thinks so, and his last call on NFLX was right on the money.